21 September 2008

Commercial Banking

Commercial banking is what we usually think of when we speak of banks: an institution that accepts deposits from customers, and loans those deposits to others at a somewhat higher interest rate. There are many varieties of commercial bank, even within the United States, but the core function is to accept deposits and re-lend the money. Banks may also be involved in the expansion of credit.

Loan Banks

An early form of bank in Britain and North America, loan banks issued paper script backed by surety of real estate, merchandise, or personal security.1 During the period 1690-1740, businessmen in France and the English-speaking world made many attempts to introduce paper money, and they kept trying despite some disastrous failures (e.g., John Law's scheme). One particular loan bank scheme set up in Massachusetts (the Land Bank, 1740) had people "subscribe" by identifying land they wished to use as collateral, plus 40 shillings for each £1000 subscribed (that's about £1 per £500 lent). The principal was to be paid in 20 annual installments of 5% each, and 3% interest per annum. The loans were to be repaid in "manufactory notes" or hemp, flax, lumber, bar-iron, cast-iron, etc. Evidently these manufactory notes were supposed to be surrogates for actual English money in Massachusetts.2

While the Massachusetts Land Bank and its local rival, the Silver Bank, were liquidated the next year by the application of the 1719 "Bubble Act", another loan bank in Pennsylvania (1722) successfully introduced paper money through small loans. The land used as security for the loans was to be twice the value of the money lent. It has been noted that these early "banks" were not banks as we understand them, but batches of money.3 However, the loan banks served an essential function of creating the financial instruments that would first be used by the banking industry.

Bank of the United States

This was the first and (until 1863) only federally chartered bank in the US; the first one was chartered between 1791 and 1811, and the second was chartered from 1816 to 1841.4 It was primarily intended to create a system of accounts in a standardized currency (this would be the US dollar, adopted 1793) and make national credit available. In many respects, the BUS served as a central bank, issuing national currency and serving as the national government's banker. However, in other respects it was merely the largest of five commercial banks, distinguished by its unique federal charter, 20% government ownership, and guaranteed federal acceptance of its notes.5 State-chartered banks regarded the BUS as pernicious competition; opposition to it and its successor, the 2nd BUS, became an early sectional issue.

The BUS did play a pioneering, at least in the Usonian experience, in monetary policy. The market for debt was not yet highly developed, and it was not really possible to influence the prevailing rate of interest, but the BUS could "inject" liquidity into the securities market by occasionally becoming involved. Politically, this was explosive, as the bank's opponents argued it was a dangerous plaything of economically useless speculators (and therefore was accused of either causing bubbles and panics, or else--by palliating them--coddling speculation).6

Commercial Banking to 1913

Banking has always been heavily regulated; it's just that the regulations are difficult to compare across epochs. The notion that the 19th century was a golden age of laissez-faire is not really accurate. To begin with, while regulations of business were a lot less complicated in the 19th century, they were usually in more sweeping terms: prohibition of branching, or extremely large reserve requirements. Requirements to redeem obligations in specie (gold or silver coin) were such that perfectly legitimate institutions, guilty only of smallness, were vulnerable to being put out of business through peremptory demands on reserves.7 While banks did issue their own banknotes until 1913, the federal government began to impose capital adequacy requirements in 1863; these were made progressively more complex to prevent evasion, and to regulate more sophisticated securities markets.8 Issuance of notes, before this, was regulated by state laws and banks were regarded by state legislatures as quasi-public entities, especially in the Mid-Atlantic: state legislatures [sometimes] authorized purchases of bank stock for newly-chartered banks, gave special recognition to banks they had chartered, and expected the banks to serve the interests of their respective states. Needless to say, each state had a different regulatory regime, and the regulations changed very often. After 1864, national banking laws effectively eliminated state-chartered banknotes, and regulated federally-chartered banknotes.

During the period between '64 and 1900, national banks became predominant, but did not eliminate state banks; typically, state banks had much lower capital adequacy standards, and were rather more likely to fail. In 1878, 6.68% of state banks (measured by assets) did fail; this is easily the worst year ever for bank failures, and in '77 only 22% of bank assets were in state banks (the corresponding losses for nationally chartered banks that year was 0.38%, the fourth worst for nationally-chartered banks during the period before the Federal Reserve Act. The worst ever for nationally-chartered banks was 0.85% in 1893. In four years, 1867, 1892, 1903, and1905, national bank failures were higher than state bank failures). During the period '63 to 1913, failure rates were very high; this was frequently said to be the result of reserve/capital adequacy requirements that tended to force monetary contractions when economic conditions worsened.

The creation of the Federal Reserve System (1913) meant an authentic central bank governed by policy discretion and countercyclical monetary policy.9 Unfortunately, there would be at least two major depressions before the Fed became effective.

Commercial Banking, 1913-present

The enterprise of investment banking and securities dealing expanded rapidly in importance in the early 20th century. Partly this reflected the growth of publicly traded corporations; prior to the Gilded Age, securities trading involved a fairly small number of stable firms. While securities and underwriting are enterprises dating back to the 16th century in Europe, they remained extremely small in scope in the US until the early 20th century.10 Underwriting was mainly the purview of merchant banks until the capital markets became fairly large and mature, in the early 20th century. Commercial banks tended to dabble in a range of financial operations as they became prominently lucrative, and by 1929, were heavily involved in both marketing stocks from the secondary market (speculating and hedging) and new issues of stock (underwriting). Banks developed notoriety for opaque blendings of these enterprises: use of assets to buy huge tranches of stocks, thereby stimulating the market briefly in order to expedite an initial public offering (IPO), then withdrawing from the market once the offering was sold, or else using the bank assets to "play" the stock market, buy outstanding shares in the inflated markets, and use the profits to manage a leveraged buyout of the bank on behalf of management.11

In the years sandwiching the abolition of the Glass-Steagall Act, a lot of papers were published at the Federal Reserve or the Department of the Treasury that sounded as if they'd been written by commercial bank spokesmen.12 Mostly these are methodologically flawed; for example, the whole point of conflict of interest between dealing securities (on the one hand) and underwriting them (on the other), or underwriting securities and lending money to the same firms, is not that the company involved is liable to do more poorly than the market, but rather, that it has such an unfair advantage that there is a generalized misallocation of resources. When a company is not allowed to fail because it would be too expensive for its sponsoring bank to let it; and if the sponsoring bank has the ability to pump gigantic sums of money into the enterprise until it's viable (perhaps because it has market dominance), then that's a deadweight loss for the economy. This is, after all, the main rationale for why command economies are unsuccessful.

In the event, financial institutions of the 1920's were Petri dishes of conflicted interest.13 While the Glass-Steagall Act was also accompanied by deposit insurance, which has played an important role in the stability of commercial banks, the G-S period of banking was a period of unusual banking stability. It may be said to have ended with the Garn-St. Germain Bill of 1982, which created a dangerous loophole for thrifts.

The Glass-Steagall Act of 1933 was an early New Deal measure. As with any public policy, it suffered from several flaws; much of the early New Deal itself was unguided by any compelling sense of direction. However, it transformed banks back into quasi-public institutions. Commercial banks were staid, cautious, and transparent. They seldom failed, and they were not big innovators.

Thrifts

Thrifts (Savings and Loan Associations) are a separate category of retail bank. Initially they were non-profit societies that took deposits and made loans. They require a separate entry.NOTES:

2 England and Scotland were merged politically in 1707 after being under identical monarchs for 106 years. The Royal Bank of Scotland and the Bank of Scotland issued pound notes identical in value to the English pound for centuries. The North American colonies had been created as private ventures under patent to the Crown, and were officially subordinate to it (rather than Parliament); the colonies during this period had their own respective currencies, and sometimes more than one (e.g., Connecticut had its own pound and dollar). The provinces of Canada mostly used banknotes from the southern colonies (chiefly Massachusetts, which first issued them in 1690), and after 1812, from their own respective provincial banks. Montreal's banks furnished most of the early dollars used in British North America, but the Maritime provinces also issued their currency, denominated in pounds. See James Powell, A History of the Canadian Dollar, Bank of Canada (2006?), "British Colonies in North America: The Early Years (pre-1841)." Link is to complete text online.

5 Robert Wright, "Origins of Commercial Banking in the United States, 1781-1830". EH.Net Encyclopedia, (26 March 2008). By 1799, the number of commercial banks in the US had risen to 33; at the time of its charter, however, the BUS was much larger than the four other banks combined (measured by capital). In 1796, the US government divested much of its stock to raise money for debts outstanding to the BUS.

7 For example, most banks issued their own banknotes prior to the 1863-1864 National Banking Acts. In New England, banks were extremely small and had no branches; banknotes from "country banks" were difficult to redeem. In 1818, the Suffolk Bank was chartered in Boston and devised an arrangement with other banks whereby it would handle redemption of most notes. In this way, the Suffolk Bank could send agents to banks in rural areas with huge amounts of banknotes from that bank, and demand specie redemption at once. Since the banks could not meet the demand, they were compelled to join the Suffolk redemption scheme, which of course imposed its own regulatory regime. See Howard Bodenhorn, "Antebellum Banking in the United States," under the entry for the "Suffolk System." Here, of course, the Suffolk System was a monopoly arrangement with kickbacks to big banks upon whom the Suffolk Bank relied.

There is a famous period of "free banking" in the USA (1837-1863), when only state-chartered banks existed. In some states, for a time, it was possible to form savings associations under very minimal regulations. See Gerald P. Dwyer Jr., "Wildcat Banking, Banking Panics, and Free Banking in the United States" (PDF), Economic Review, Federal Reserve Bank of Atlanta (Dec 1996). However, what free banks could actually do was very highly restricted.

9 "Countercyclical" means that the policy taken by the authorities (either in the money supply or aggregate demand) is in opposition to, and therefore counteracts, the [business] cycle. For an explanation of the general concept, see Satyajit Chatterjee, "Why Does Countercyclical Monetary Policy Matter?" (PDF), Business Review Federal Reserve Bank of Philidephia (1Q 2001). On the effectiveness of the Fed in preventing or causing depressions, see Milton Friedman & Anna J. Schwartz, A Monetary History of the United States, 1867-1990, Princeton (1971), Chapter 7. While there is ample criticism of F&S's thesis, this part of it is not very controversial.

The caption to the chart includes a link to the EH.net article with the source data, but I used an Excel spreadsheet to determine the rates of banking failure.

10 Getting a grip on the comparative size of securities dealing is extremely difficult. Most histories like to cite some amazingly early date, such as the founding of the Amsterdam Stock Exchange in 1531, or the Buttonwood Agreement that created the New York Stock Exchange (sort of) in 1792. Sobel (1988; see note 6) mentions several manias that gripped New York City or the nation, but these either (a) involved very small numbers of people, or (b) were a transcient fad, like the "scriptomania" of 1792. When an activity like securities dealering to the general public becomes economically significant, it tends to come under regulation. This first took place in Kansas ("A Brief History of Securities Regulation," State of Wisconsin Department of Financial Institutions). The SEC was created in 1933, and established minimum national standards for the first time in US history.

Milton Friedman & Anna J. Schwartz, A Monetary History of the United States, 1867-1990, Princeton (1971), esp. chapters 2-4. F& S find the Greenback period (1863-1879) extremely interesting, and it receives almost as much scrutiny as the onset of the Great Depresssion (1929-1933); writing in 1971, they were totally amazed by the idea of freely floating, non-redeemable currency, with inflation rates of almost 4.5% annually. This is, of course, the way things have been for the last 35 years.

20 September 2008

Epitaph for an Industry: Investment Banking

Investment banks have long been separated from commercial and savings banks by federal law. When we speak of a "bank," we usually think of a business that takes money from depositors (savings accounts, savings accounts, money market accounts) and lends to other entities. The bank's income comes from the spread between the interest rate it pays on deposits, and the [higher] rate it charges on loans. This is not what investment banks do.

Deserted interior,Lehman Europe HQ, Sep 2008Click for larger image

An investment bank's customers are corporations issuing stock, bonds, or paper.1 When a company wants to issue stock, it approaches an investment bank to raise the money. The investment reviews the prospectus for the issuing firm, carries out its own research, and determines how much money can be raised on the capital (stock) or money (bonds, paper) markets. It draws up the actual securities and buys them from the client, then sells the securities on the capital markets. The difference between the face value of the stocks and their sale price is the IB's main source of revenue.

If the share issue is quite large, then the IB usually spreads the risk through syndication. The primary IB in contact with the issuing firm contacts other IB's and invites them to buy a share of the security issue; in the case of paper, the issue is routinely absorbed by a money market fund.2 Members of the syndicate usually make a firm commitment to distribute a certain percentage of the entire offering and are held financially responsible for any unsold portions. Selling groups of chosen brokerages assist the syndicate members meet their obligations to distribute the new securities. Members of the selling group usually act on a "best efforts" basis and are not financially responsible for any unsold portions.

IB's are not a very large sector of the Usonian economy: about $200 billion in total revenues for 2006,3 or probably 31% the size of the commercial banking sector.4Fannie Mae and Freddie Mac belong to neither sector. However, the smallish revenues belie the great importance of this business to the world economy. The US IB sector is immensely important to the coordination of capital markets; it mediates the best available data on sector growth in other industries, soundness of management at individual firms, etc., into capital allocation (bond and stock issues). Commercial banks traditionally address more routine needs for loans; they are usually more interested in the firm's balance sheet, rather than its long-run outlook for expansion or diversification. In a way, IB represents a disembodied and convicted guide to world industry, a not-so-invisible hand with its own peculiar ideological proclivities.

One of the most important New Deal measures was the Glass-Steagall Act (1933), which created firewalls between the different functions of banks. The most important of this was between investment banking and commercial/savings banking; another isolated financial firms generally from non-banking activities. After 1960, the Glass-Steagall Act was eroded by loopholes, until the last barriers were dissolved (1999); the financial services industry was opened up to homologization. There was an immense spike in the number of mergers, and in the value of the deals.5 Nearly all recent literature reviewed (i.e., published pre-2008) is emphatically in favor of even more consolidation, with the claim that further homologization in the financial services industry has created intense competition. Judging by the Japanese experience of the late '90's, it seems plausible that the banking regulators will see consolidation as a low-cost way of resolving bad balance sheets.

As of this writing, the IB industry has been almost completely annexed to other financial services, and we can safely assume the age of the universal bank/financial supermarket has arrived. On Wall Street, only two independent investment banks remain: Morgan-Stanley and Goldman-Sachs; the latter is extremely well-connected politically.6NOTES:

1 "Paper" (commercial or government) is short term debt; it is usually acquired by money market funds, because it affords extremely low risk.

2 Money markets deposit accounts were an early breach in the wall between investment and commercial banking; they were accounts offered by banks whose value was tied by an index to the money market funds (1982; "Money Market Deposit Account," Financial & Investment Dictionary). They are required by law to invest in federally listed low-risk securities, of which paper is a major part. See "Money Market Funds," US Securities Exchange Commission, specifically the "Investment Company Act of 1940" (PDF). Commercial paper is not a very important market; it only accounts for $150-200 billion dollars of debt at any time (Federal Reserve). Money market fund balances are around $3.2 trillion (retail + institutional); see "Economic Indicators," GPO (July '08); they've become a rather important component of M3.

5 Data on M&A activity specific to banking is proprietary; however, one source is Steven J. Pilloff, "Bank Merger Activity in the United States, 1994–2003" (PDF), Board of Governors of the Federal Reserve System (May 2004). The largest spike was in 1998, the year before the much-anticipated dissolution of Glass-Steagall. However, this was mainly due to the merger of CitiCorp with Travellers.

Asst Secretary of Treasury Neel Kashkari (Financial Stability) is a former VP at Goldman Sachs. He was appointed to this job by his once-and-present boss, Henry Paulson, 8 October (yes, this is an update);

However, it appears so far that financial contagion originated in the USA and spread to other countries via their immense holdings of dollar-denominated assets. A logical corollary to this, in my view, is that for decades assets based in the USA and denominated in dollars were so popular that, despite our immense and growing trade deficit, non-Usonians would buy financial assets with the huge pools of dollars they acquired from ordinary business. Now, it seems as though dollars will be seen as having the same systemic risk as Korean won or Thai baht.SOURCES & ADDITIONAL READING:

10 September 2008

Fannie Mae and Freddie Mac

The Federal National Mortgage Association (FNMA) was created in 1938 by Act of Congress. The purpose was to purchase loans from conventional lending institutions, such as thrifts, thereby reducing the risk to the firm originating the loan. In order to ensure the loan was worth something, the new Federal Housing Authority (FHA) investigated the terms and the property before permitting the FNMA to buy the loan. In a very short time, the FNMA became a de facto monopoly for home loans, even though it did not originate any; all of the nation's lending institutions simply deferred to its FHA guidelines on making loans, and then passed them on to "Fannie Mae." In 1944, VA loans were added to the FNMA portfolio.

This is credited with stimulating a postwar boom in new housing; loans were now virtually risk-free to the originator, and easy to obtain.

In 1968, Fannie Mae was privatized; at the same time, a large segment was spun off as the Government National Mortgage Association (GNMA), which remains a division of Housing and Urban Development (HUD). GNMA specialized in special government development programs and higher risk loans; by 1997, it (rather than Fannie Mae or Freddie Mac) handled 95% of FHA loans, and 13% of residential loans.1 Ginnie Mae does not buy or sell loans or issue mortgage-backed securities (MBS); instead, it guarantees loans for fourth party issuers such as Countrywide or Wells Fargo.2

Two years after the split/privatization of Fannie Mae, the Federal Home Loan Mortgage Company (FHLMC, or "Freddie Mac") was created by Congress explicitly for the savings association system (thrifts).3 Freddie Mac usually buys loans with higher credit ratings than Fannie Mae does, and it favors special savings association loans; according to Wikipedia entries, the 2007 assets of Fannie Mae were $882 billion, and those for Freddie Mac were $794 billion.

Freddie Mac and Fannie Mae are both known as government-sponsored entities (GSE's); in addition to the $1.68 trillion in assets that they hold in their portfolios, they sell an immense number of MBS's. Ginnie Mae, as mentioned above, contracts out the mortgages to fourth parties; assets held by it are not available.

A Brief Description of Mortgage-Backed Securities

When a mortgage is purchased by the GSE's, it becomes part of an immense pool of assets. This pool is divided into numerous subdivisions based on comparative risk; tiny pieces of the total are sold off as securities. The risk of default on any loan is distributed therefore evenly across all of the loans in the pool. MBS are commonly referred to as "pass-through" certificates because the principal and interest of the underlying loans is "passed through" to investors. The interest rate of the security is lower than the interest rate of the underlying loan to allow for payment of servicing and guaranty fees. Ginnie Mae MBS's are guaranteed by the full faith and credit of the federal government. Whether or not the mortgage payment is made, an investor in a Ginnie Mae MBS will receive payment of interest as well as principal. In the case of Fannie Mae/Freddie Mac, there is considerable variation in available instruments.

In 1983, Freddie Mac introduced a variation on the MBS called a "collateralized mortgage obligation" (CMO). The CMO segments the cash flows from the underlying block of mortgage loans into four basic classes of bonds with differing maturities. Prior to the CMO, FNMA and FHLMC issued plain vanilla MBS's like the ones described above. The CMO prioritized payments received; high priority meant low risk (and therefore, low—but reliable—ROI), while low priority meant high risk (and therefore, potentially high ROI).

The GSE's: Public or Private?

Ginnie Mae is a division of the Department of HUD; it's obviously a public sector entity. It carries no MBS's on its balance sheet. Fannie Mae and Freddie Mac became private sector entities when they issued public offerings of stock (1968 and 1970, respectively). Incidentally, I've noticed some confusion between "private sector" (which means, "non-governmental, for profit") and "privately held" (which means, there is no publicly issued stock in the firm). A publicly-held corporation usually is run for a profit, but has traded shares; a privately-held corporation is also run for a profit, but it's not possible to buy shares in that company. The GSE's were publicly traded until the recent melt-down wiped out 99.4% of their value.

However, as private-sector entities, there were some peculiarities about the GSE's:

Five members of the board of directors (a minority) were appointed by the White Houst e;

The Secretary of the Treasury could invest up to $2.25 billion in GSE securities;

They were exempt from corporate income taxes;

Their debt securities were eligible as collateral for federal government deposits of tax revenues in private banks;

Risk-weighting of their securities was only 20% for banking capital, as opposed to 100% for private-sector companies (under the terms of the Basel 2 Accords—PDF)

The last point is somewhat arcane, but the Basel Accords (1 & 2) were agreements to regulate the capital requirements of banking institutions worldwide; the purpose was to ensure that banks based in countries with lax standards would not have a competitive advantage vis-à-vis banks based in countries with sound standards. Banks based in the USA were allowed to use GSE shares to meet capital adequacy standards, with the understanding that GSE shares were effectively gold-plated.

Not surprisingly, the GSE's were regarded with hostility by the rest of the financial sector since they competed on a very uneven playing field. While lobbyists for the GSE's argue that the above features ensured that their funds cost the government nothing (and Fannie Mae/Freddy Mac were required to warn investors that their issues were not backed by the federal government), the Congressional Budget Office estimated that the opportunity cost to the federal government amounted to $6.5 billion annually (1996), of which $4.4 billion was passed through to customers. A 2001 survey revised the estimate slightly downward, to $5.4 billion in '95 and $10.6 billion in '00. Projections in the same report suggested this would reach $13-16 billion by '08.

There's some controversy over the cost of this. The CBO's estimates include a few hundred million in lost tax revenues, combined with several billions in opportunity costs. In other words, either the GSE's ought to have done something more with the off-book assets they enjoyed (e.g., used their fiduciary role to require better urban design, and subsidized the marginal cost) or else given the federal government the money. The money was "captured" from the financial services industry and its customers by the peculiar financial advantages the GSE's enjoyed.NOTES:

Fourth party issuers: the first party is the home buyer; the second is the firm that originates the loan. GNMA (third party) guarantees the loan, and the approved issuer (say, Countrywide or Wells Fargo Home Mortgage) issues the actual GNMA MBS. Countrywide was the largest approved issuer in '07, writing $20.6 billion in MBS. The fifth party is anyone who buys the MBS.